Why gold mining shares look cheap
Gold has performed very well in recent months - but gold mining stocks are failing to keep up. Here's why the sector could rise by at least 38% before the end of 2006...
See MoneyWeek's Gold section for the latest news on gold miners' stocks.
Gold's recent performance has been very satisfactory. It is currently consolidating above $550oz, whilst silver and platinum have just made new highs. In no way will platinum and silver go meaningfully higher and gold go meaningfully lower.
In June 2005, we reported on the long-term relationship between the price of gold bullion and gold shares. There is a ratio that is calculated by dividing the price of the Philadelphia Exchange Gold and Silver Index (XAU) into the gold bullion price. At that time, the ratio was 5.
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We went on to explain that this was an extreme number indicating that gold miners' shares were priced poorly relative to the price of gold bullion and what should follow would be a move to a ratio of 3. Research into this matter conducted by RBC Capital Markets led them to say that following a ratio of 5, the next 12 months have invariably been very positive for gold mining shares, as the ratio moves from 5 to 3. The historic data justifying this was very significant.
On 1st June gold bullion was priced at $415oz, the XAU $86, so the ratio was just below 5. At the time of writing gold bullion is at $561oz and the XAU is at $145. The ratio is now 3.87.
If the ratio is to fall to 3 - and let's for this purpose presume that gold bullion later this year is at $600oz (not an unreasonable possibility) - then for a ratio of 3 the XAU will be $200, compared to $145 today. On that basis there remains 38% or more upside for gold miners' shares.
The fact that the gold bullion bull market is now early in its second stage, makes it not unreasonable to suppose that later this year the gold price will be higher than now. Especially if, as we think, the dollar is on the verge of a serious period of weakness.
By John Robson & Andrew Selsby at RH Asset Management Limited, as published in the Onassis Newsletter, a fortnightly newsletter that gives insight into the investment markets.
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